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Markets expecting relief after Moody's refrains from downgrading Italy to junk

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There are still plenty of question marks hanging over Italy as its swollen debt relative to gross domestic product gives the government little financial wiggle room.

London

ITALIAN government bonds, stocks and debt from Europe's other peripheral nations may rally on Monday after a ratings decision by Moody's Investors Service removed the immediate threat of a downgrade to junk.

Moody's cut Italy's credit rank by one step to Baa3, its lowest investment-grade rating, on concerns the government's budget will erode its fiscal strength and stall plans for structural reform.

But its decision to set the outlook for the assessment at "stable" may be enough to reassure investors after a selloff pushed yields on the nation's 10-year bonds to the highest since 2014.

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"This was the softest move possible and should be a relief for investors," Ciaran O'Hagan, head of euro-area rates strategy at Societe Generale, said in emailed comments.

He recommended investors buy Italian government bonds after the decision. "Uncertainty has been removed. This deserves to be rewarded with a good rally."

Italy's financial markets have been under pressure since the coalition government pushed for a higher-than-expected deficit in its budget, damaging investor confidence in its ability to reduce its 2.3 trillion euros ($2.7 trillion) debt load and setting it on a collision course with European authorities.

It also raised concern that ratings firms would cut the nation to below investment grade, triggering forced selling of government bonds.

While it leaves Italy with its lowest credit rating since the euro was formed, Moody's downgrade fell short of investors' worst expectations, paving the way for a relief rally. The 10-year yield touched 3.81 per cent on Friday, a level last seen in 2014 when the nation was still recovering from Europe's sovereign debt crisis.

And while securities did stage a late-day bounce to close at 3.48 per cent, that's still more than double this year's lows and represents a premium of more than 300 basis points over benchmark German bunds.

By some measures, Italian bonds had already been trading in line with junk-rated nations.

SocGen wasn't alone in expecting Moody's to stick at a "stable" outlook. A one-step downgrade may see the 10-year yield spread narrow toward 250 basis points, Banco Bilbao Vizcaya Argentaria said before the decision.

Strategists at Citigroup said the yield gap would drop below 300 basis points in their base-case scenario of a one-notch downgrade and the removal of the negative outlook.

S&P Global Ratings, which rates Italy two notches above junk, was due to review the country on Oct 26. Having upgraded Italy this time last year, that company "is not going to want to yo-yo around", SocGen's Mr O'Hagan wrote.

Still, there are plenty of question marks hanging over Italy. Its swollen debt relative to its gross domestic product gives the government little financial wiggle room, while the government remains under pressure due to internal disputes within the volatile coalition at home and European Union criticism of the budget abroad. BLOOMBERG